Sunday, December 15, 2013

"Investors and regular workers with a Western slant do not grasp what wealth is. Overwhelmingly they see their currency and paper investment portfolios on an equal footing in value with the same
"real things" that raise our living standards. Yet, in real life, they cannot be equal because these paper assets are only an exercise able future claim on our "real things in life". –FOA

The super wealthy pay way too much for some stuff, don't they? I mean, $490,000 for a used old card table? I can get a brand new card table for $40, but here's a much nicer one for $280.

I caught a few minutes of the Antiques Roadshow the other day. Mrs. FOFOA had it on and I was passing through the room, but somehow that show grabs you and you have to stay to find out what the item they're examining is worth. This one was an old, wooden card table, originally made in Pennsylvania, and long ago refinished. Some lady had brought it in to have it appraised on TV. It was pretty nice, mahogany wood, claw and ball feet, and it had a swing-out leg that supports a hinged extension of the table's surface. The appraiser told her it was worth $250,000 to $350,000, and if it hadn't unfortunately been refinished years ago, it could have been worth up to $500,000 today.

I tried to find that episode online while writing this, but I only found a similar one. It's another card table they appraised for $200,000 to $300,000 and, when it actually went to auction at Sotheby's, it sold for $490,000! You can see the original appraisal here and the actual auction here.

What makes a second-hand card table worth $490,000? It's certainly not the need for a surface on which to play cards. That need can be met for much less money. You know what it is? It's that the wealthy fill their lives with otherwise-common items that perpetually rise in value, while we do the same with similar items that lose half their value, never to be regained, the minute we take them out of the store.

Two tables. One is $280 and the other is $490,000. The difference between the two is that the price of the former comes from demand related only to the service it renders in its specific form, as a table, and the latter comes from demand related to two different services it renders, that of a table and also that of a store of value.

I have explored this concept in many posts. It's not a new concept in any way, shape or form. In fact, man was using real things as stores of value, often in preference over their other uses, long before any labels were applied to this specific utility or function.

Take the $490,000 card table for example. We could say that the buyer paid $280 for a table, a well-crafted and nice-looking flat surface with four legs, and another $489,720 for a store of value. When you look at it this way, it starts to make sense why the wealthy often buy such remarkable "real things" and then hide them away for decades, packed in unassuming wooden crates, in places like this—Über-warehouses for the ultra-rich—rather than "using" them in their homes.

Which would you say is a $490,000 table's primary function or utility? As a table, or as a store of value? Obviously it can function both ways, but if someone pays 1,750 times more for one function than for the other, I think it would be fair to say that is its primary function.

The high price of these items which function primarily as stores of value comes from the demand for that specific function. Such demand creates a market and, thereby, the high marketability of such items. This is the network effect. And the long history and past success of such markets engenders the confidence in those who possess (and seek) such unique items that, when needed, they will be able to find a buyer ready to pay the highest price which can possibly be attained. This is what I like to call the regression effect. And while past performance is certainly no guarantee of future performance, especially in unique, one-of-a-kind collectibles, our natural tendency to believe that what worked yesterday and still works today will work again tomorrow does create a very real effect with very real results.

I hear that Christie's is booming these days. Here are just a few of the auction-related articles I've collected over the past two months:

"In this world we all need much; blessings from above,,,,, family,,,, home,,, friends and good health. But after all that, one must have currency and an enduring, tradable wealth asset that places our footing in life on equal ground with the giants around us,,,,,, gold!" -FOA

"The world’s rich are increasingly investing in expensive stuff, and “freeports” such as Luxembourg’s are becoming their repositories of choice…

Because of the confidentiality, the value of goods stashed in freeports is unknowable…

Collectibles have outperformed stocks over the past decade…

The goods they stash in the freeports range from paintings, fine wine and precious metals to tapestries and even classic cars…

These giant treasure chests were pioneered by the Swiss, who have half a dozen freeports, among them sites in Chiasso, Geneva and Zurich…

The wealthy are increasingly using freeports as a place where they can rub shoulders and trade fine objects with each other. It is not uncommon for a painting to be swapped for, say, a sculpture and some cases of wine, with all the goods remaining in the freeport after the deal and merely being shifted between the storage rooms of the buyer’s and seller’s handling agents…

Gold storage is part of Singapore’s strategy to become the Switzerland of the East… To spur this growth, it has removed a 7% sales tax on precious metals…

Switzerland remains the world’s leading gold repository. Its imports of the yellow metal have exceeded exports by some 13,000 tonnes…

Did you notice anything about the stuff the "ultra-rich" are stashing at those freeports? For one thing, most of that stuff is out of reach for the average saver. Most individual items that make their way to these storage facilities cost more than the average person makes in a year, and some cost more than he'll make in a lifetime.

Gold is the only "real thing" used by the wealthy, for this specific store-of-value function, that is also available to anyone. What's more, the gold of the everyman is the exact same quality gold that is held by the Giants. The same cannot be said about the paintings, sculptures, tapestries, cases of wine, classic cars or even the card tables held, and used, by people of average means.

I have everything on that list, except a classic car (although my car is 12 years old now, so I'm getting close). The difference is, I hold each of those items for the service it renders in its specific form only. My wine is for drinking and my art livens up my home. I have bought and sold an entire home-worth of expensive furniture, and I can tell you that, no matter how much I paid for each wonderful piece, in order to sell it when I needed to, I had to cut the price considerably.

Storage and moving expenses can greatly increase your cost basis in items that are only depreciating over time. This was why I decided to sell everything the second time I moved cross-country. It was a good decision, but what I learned was that, for the common man, household items, no matter how nice they are, are generally poor stores of value at our level.

That's not to say you can't do well with certain types of items, especially if you take your time selling them. I had a Dr. Who pinball machine which I sold for quite a bit more than I paid for it. But I took my time selling that item, and if I add the maintenance and expense of moving it cross-country to my cost basis, it was probably a wash, although I did get hours of enjoyment out of it. Then again, I didn't buy it as a store of value.

I do know a few people who buy fine wine by the case, numismatic coins, expensive paintings, pottery and even sculptures with the idea that these items will render the dual services of practical use and store-of-value. In some cases, a portion of their high price does indeed come from demand for the store-of-value function, but in most cases, at our level, the majority of the price comes simply from the demand for an exclusive level of quality. Exclusive items are sometimes called Veblen goods.

There's nothing wrong with enjoying an exclusive level of quality if you can afford it, but I want you to think about how these exclusive-quality items that may be within our reach actually compare to the ones used by the uber-wealthy. The difference really comes down to the magnitude of the proportion of their high price which was derived specifically from demand for the store-of-value function, as opposed to the item's practical use as a high-quality exclusive showpiece.

This store-of-value demand is the demand which creates a deep and liquid second-hand market for these "overpriced" items. Did you buy your collectibles from a store, or at an auction? If you bought at auction, how many others in the room also bid on your item? Is the maker of your precious item still alive? If you decided to sell your showpiece, how would you sell it? To a store? On consignment? On Craigslist or eBay? Is there a good auction house in your city? Do you have any idea how much commission auction houses charge? How long do you think it would take for you to find a buyer who would pay the highest price which can possibly be attained at any time? If you had to sell in a hurry, do you have confidence that you could attain the highest price?

These are all unique items we're talking about, so there is no standard that applies across the board. But over long stretches of time, some unique items climb a certain "store-of-value pyramid" while others don't. I like to call this the focal point effect. Take Andy Warhol for example. With one of his paintings selling for more than $100M, he has risen to become a kind of focal point among the various pop art painters of the 60s.

Does this mean that Warhols are in a bubble and a Rauschenberg at $10M would be a better investment? Perhaps, but I don't think so. And I'm sure that this view misses the point I'm trying to make. Since we're talking about unique, one-of-a-kind items, one can certainly pay too much for any single item. But in a proper auction setting, there will either be many bidders, or else you won't be bid up higher than you planned on paying. It is the focal point effect which adds the depth and liquidity to the highest-of-high-end auctions that gives the owners and seekers of such items the confidence that, if and when it comes time so sell their particular item, they will be able to attain the highest possible price at that time.

That focal-point-marketability is precisely what makes the very best-of-the-best stores of value. It is what drives some things to many multiples of the "intrinsic value" of their component parts, i.e., frame, canvas, paint and an aesthetically-pleasing image, while leaving others in their dust. So, in this case, a Warhol might be a marginally better store of value than a Rauschenberg, although you could have paid more for the latter in the 60s. In fact, you can still buy 60s pop art originals on eBay today for a few hundred bucks. Note that it's not the death of the artist that drives the focal point effect. There are plenty of dead artists. It's just that it takes time for the focal point effect to emerge and mature to this top level, usually longer than the normal human life span.

Surprisingly, however, that's not always the case. You might think that the anonymous telephone bidder who paid $58.4M for "Balloon Dog (Orange)" last month paid way too much, especially considering that, not only are there four more balloon dogs just like it, in arguably better colors than orange, but more importantly, the artist is still alive. And he's only 58 and still producing! But considering that there was a competing bidder willing to pay $57.3M ($51M + commission), how can anyone say he paid too much?

The seller of "Orange Dog" was Peter Brant, the 500-millionaire who is married to supermodel Stephanie Seymour. "Blue Dog" is owned by billionaire Eli Broad and is currently on display at the Los Angeles County Museum of Art.

"Magenta Dog" is owned by French billionaire François Pinault (but that's the artist Jeff Koons, not Pinault, in the photo):

"Red Dog" is owned by Greek billionaire Dakis Joannou:

And "Yellow Dog" (my favorite, although I would have called it "Gold Dog") belongs to billionaire hedge fund manager Steven A. Cohen:

Call it "Focal Point-Balloon Dog"! It doesn't have to make sense to you, it just "is". But does that mean that all of those balloon dogs are each worth $58.4M now? Of course not. With these kinds of items, we don't know their price until after they are sold at auction.

Here are some interesting statistics. According to Investopedia, experts estimate that only 0.5% of paintings bought are ever resold, and public auctions account for only a small portion of those resales, with private transactions accounting for the rest. At the high end, fine art auction houses are the best way to attain the highest possible price at any time, but they can cost you anywhere from 3% to 50% of the sale price in some cases. The commission on "Balloon Dog (Orange)" worked out to about 12.3%.

Tracking or indexing markets for unique, one-of-a-kind items, like art, is different from tracking stocks, bonds and commodities. It's more like residential real estate due to the infrequency of trades and the uniqueness of each item. To create a useful index comparable to stocks, bonds and commodities, you can't just track the average price of sales over a period of time, since each item sold is unique. Instead, you would want to create a database consisting only of repeat sales of the same exact objects.

Two New York University professors, Jianping Mei and Michael Moses, did just that. They created the Mei Moses Fine Art Index based on a database they built which now contains over 30,000 repeat sale pairs for approximately 20,000 individual works of art. They are constantly adding to the database using mainly the public results of auctions conducted by Sotheby's and Christie's from around the world.

What they found was that the compound annual return on fine art exceeded stock market returns on 5- and 10-year timelines, but that the stock market outperformed art over the last 25 years. However, for the last 50 years, the returns were very close, with fine art achieving a compound annual return of 9.23% compared with 9.73% for equities.

Now I should point out that the purpose of this index is to compare stores of value with investments to encourage investors to incorporate them into their investment portfolios. Such is the Western investor mindset. Like paper gold, there's even a kind of "paper art". According to Investopedia, fine art funds typically use leverage to buy art, have a minimum entry investment of $250,000, and for that you will receive a diversified portfolio of art, annual statements and appraisals for the artwork.

Everyone knows that western minds don't like or want gold, but if they think you like it they will trade it up in price for the sake of "sticking it to you." Enter the world of "paper gold." –Another

If you buy into one of these art funds, you won't actually have pieces of art. You will, instead, have a securitized fractional interest in a stash of real art, kind of like owning a fractional interest in a real Giant's store of value. Only it won't be managed like a Giant would manage his stash, buying focal point winners and selling the losers until all he has left are the winners. Instead, a fund manager will decide which pieces of art will be purchased and sold, and his only concern will be the short term gains made from selling the best pieces so that he can make his 2+20. Another called this "a western way," to "cut the winners and let the losers run."

The thing about this focal point effect I'm trying to explain is that the winners rise to the top and just keep on rising, well out of reach for all but the Giants. What makes something one of the "best-of-the-best" is not its superior quality or age, but simply the focal point effect, which essentially means that Giants have already voted for it in the only way that matters, with their pocketbooks.

True Giants are extremely strong hands when it comes to stores of value. They generally have no financial need to sell anything, so when they do, it is often because they are "trading up". In this way, the very best-of-the-best items tend to make their way into the strongest hands where they just "lie still" for generations. And, of course, we cannot know the price of such best-of-the-best items except on the very rare occasions when they are put up for auction.

If we could, somehow, hypothetically, come up with an objective way to identify the best-of-the-best as a class, and also track their progressive appreciation, I think we'd probably find a lower but much more dependable (less risky and more homogeneous or uniform, especially over the long run) rate of appreciation than the Mei Moses index would otherwise lead us to believe. Of course, this is impossible to know, because the best-of-the-best focal point winners I'm talking about are the ones that never go up for sale, kind of like the Mona Lisa, so we will never know their price. All we can do is guess.

Here's where it might get a little bit difficult to follow because you'll need to think like a Giant. While these "best-of-the-best" items are perpetually appreciating, hypothetically at a remarkably dependable rate, and while that seems very appealing to us shrimps, it has nothing to do with the reason the Giants buy these things. Giants buy these things simply because of the regression, network and focal point effects that engender the confidence that, when needed, they will be able to find a buyer ready to pay the highest price which can possibly be attained at that time, whenever it may be.

It is, quite simply, the inherently-strong hands of the Giants that instill such remarkable dependability in the "best-of-the-best" focal point stores of value. If Giants suddenly had weak hands, and all such items were to hit the market at once, this would obviously no longer be the case. But that clearly doesn't happen, precisely because such items are only within reach of true Giants, who, by definition, have inherently strong hands.

We know this is true by the simple fact that these items I'm calling "the best of the best" so rarely come to market. Once they make their way into the strongest hands, they just sit there, lying still for generations. And this is why, on the very rare occasion that one hits the market, we see other Giants falling all over themselves to get it, bidding that item up to well above all "rational" expectations and, without fail, setting a new record. It's quite literally something that's only available to Giants, and you almost have to be one to even understand it. And because these items I'm talking about always sell for more than can "rationally" be expected or explained, they will never end up in one of those art funds. Only a true Giant can understand the "rationale" behind "paying way too much" for something.

And then there's gold. But I'm not talking about today's (quote-unquote) "Gold". I'm talking about physical gold, the singular item in that Economist article above which is not only hoarded by Giants, but is also available to anyone and everyone. If you can wrap your head around the concepts—the effects—that instill such remarkable store-of-value functionality in the best-of-the-best real things as I have explained them, then I am here to tell you that physical gold is even better!

ANOTHER: The gold market is made up of a very broad spectrum of investors. At the very farthest ends of this spectrum lie the persons with the largest influence on the physical bullion. The super wealthy at one end and the "third world no ones" at the other. The middle is occupied, mostly, by the "investors with western thought". The far ends buy bullion. And they don't buy it as a gamble or a game! It is a way of life that has worked, through thick and thin, even before the West was "The West".

Now, on the other hand, this "modern day middle of the spectrum"! Well, they have read why we need gold, but they have never "Experienced" the need for gold! Until that day, when they gain "Experience", most of them will make "A Gamble That They Never Intended To Take". Yes, they do invest in all forms of paper and or leveraged gold and all the while, expounding from the roof tops the coming currency crashes and stock market declines. Even looking for bank closures and bank runs, as they cling dearly to comex options and gold stocks!

Anyone, from the outside looking in can clearly see that "westerners" do lack "experience".

There is a "flaw" in this modern market that many do not quite grasp. In time, they will! There have always been people and companies that make a living dealing in gold. It is an ages old business. Today, we see a phenomenon that is "as none before". It is mostly done by the investors at the middle of the spectrum. The "trading of gold" has grown to a level never seen in history! You read every day, that no one wants or needs gold! In a way those statements are very correct! No investor wants to hold gold, but everyone and his brother ( and sister ) wants to trade it! The volume of paper trading, worldwide, on and off market is beyond belief! It has created a type of "Parallel Paper Gold Universe", existing side by side with the physical. The major "flaw" in this system is found in the makeup of the "traders" of this "paper gold universe". Without fail, the majority is made up by those in the "middle of the spectrum", those without "loss of currency "Experience" ". Mostly, they are of "western thought".

I have tried to offer these thoughts as a way for many to understand why this modern gold market is not as before. Most of these letters apply to investors at the far two ends of the market ( see my last post ) . Many, from other places, do understand these "expressions" as given. For many here, I resist the replies to questions that offer results for "gold traders". The intents and reasons are for persons to "consider" and "see" this market in a true light for today. Not for paper trades that will lead to certain loss for the future. I now believe, that by way of other posters, these thoughts are "in grasp" by many traders of "western thought". One may not "accept" the conclusions, but they can, "mentally experience the outcome" of the future. For this end I will now offer real direction. That of Why, When and How Much! I do this for those of "Family and Country", and persons of Honor. Those that live to help, not take, in times of change! Some say this knowledge should not be in a "public way", but I say secrets are for fools.

We must grasp that all commerce is done, at least, in the US dollar concept of "valuations of real things". In this way, " the true value of the purchase of real money" is hidden from view! Persons will say in the future, "how could gold be $500 one day and $5,000 the next"? I tell you now, it is already past that level, as in "present reserve currency dealings" it is not seen! Consider, that in all that you do and think, your "western values" are of paper concepts. From your birth, real things are not used to cross value themselves! When the battle to keep gold from devaluing oil ( in direct gold for oil terms ) is lost, the dollar will find "no problem" with $30,000 gold, as it will be seen as a "benefit for all" and "why did noone see this sooner"?

Now when I say that physical gold is even better, I'm not talking about carrying it through the revaluation. I'm talking about after the revaluation. But to understand what I'm trying to say, I think you need to put your mind there, into the future, to "mentally experience the outcome" of the future, which is why I included that bit from Another. He lays it out quite clearly. Today's gold market consists of a "Parallel Paper Gold Universe" used by "investors with western thought," and real physical gold used by Giants and "third world no ones" for generations.

Physical gold is the one real thing that puts Giants and "third world no ones" on equal footing. Third world no ones certainly don't buy $100M paintings, $50M balloon dogs, or spend half a million on small tables with their surplus income. But they do buy gold as a tradable wealth asset, that singular real thing (focal point effect) in which its perceived value comes from a very long history (regression effect) of broad demand (network effect) for its store-of-value function above and beyond any other services it renders as a shiny and malleable metal.

But what about those "investors with western thought"? If "Street Gold" and "Paper Gold" are going to part ways, does that mean gold will play no future role in the West? Of course not. The fact of the matter is that a large slice of today's "investors with western thought" are not true investors at all. They are conservative savers, which means they are inherently more like the Giants and "third world no ones" in terms of how they prefer to deploy their surplus income. Investor money is called "hot money" because it's always on the move, looking for the next great yield, which requires a certain amount of expertise and focus on the specific activity of investing. Saver money, on the other hand, is "cold money" as it lies very still, which requires a focal point store of value. Gold is for savers:

"[Another's] message and proposition was never for a trader's mindset or time frame. Indeed, his direction was for simple savers, like you and me… As I hold my gold for the money it is, traders will work all these markets as they must… most "physical gold" savers will find themselves "many steps" ahead of the "Western trading community" as this plays out… gold money was/is but a representation of the real tradable wealth you saved over a lifetime of work… This "long term gold accumulation" proposition was given some time ago, to induce conservative people to begin saving gold "now"… You see, there is a world of difference between saving real money as a "wealth of ages" and trying to trade this world's "paper derivatives"… These years be right for ones who save gold." –FOA

FOA called this function or utility "wealth money", which denotes both the physicality of the item (wealth) such that it represents true settlement—an exit from the monetary plane—as well as the primary source of its demand, which is above and beyond any other physical services it renders (money). But gold doesn't quite fulfill this "equal footing" promise yet today, as anyone who first purchased gold in August or September of 2011 can attest. It will, but not until "Street Gold" and "Paper Gold" part ways.

Of course, the time preference of non-giant savers is higher (shorter) than it is for true Giants. So for gold to be on equal footing with the likes of "Balloon Dog (Orange)" and "Silver Car Crash (Double Disaster)", it will need to have a few differences that make it much more amenable to turnover on a shorter time frame. And it will. It already does!

For one thing, the transaction cost is, and will be, much smaller than the 12% to 25% commission that top auction houses charge for selling high-end items. For gold it's around 5% today, and will probably be much lower at a higher price. Low transaction costs are important because they must be overcome and recouped through appreciation within the minimum preferred time frame. Likewise, the cost of storage and security must be recouped through appreciation. It costs a lot more to securely store a 12 foot-tall balloon dog than it does to store 1,000 ounces of gold.

These costs, round-trip transaction cost plus secure storage, compared with gold's real appreciation (appreciation in real, not nominal, terms), will naturally match the time preference of savers for settling physical plane imbalances versus carrying a monetary plane balance. In other words, the cost of carrying a cash balance will be compared to the cost of buying "wealth money" over a short time frame.

How short of a time frame, you ask? I can only guess, but I can easily imagine a round-trip transaction cost of 2% and an annual insured storage cost of around 0.1%, with a real appreciation of 1%++ per year. So that would put the minimum time frame for settling a monetary plane surplus at about 2 years, which is a good time horizon for known and expected expenses for which you'd want to carry a cash balance.

It is remarkable that gold and the physical part of the market are already so well-suited for this role and function. Large volume gold dealers make millions today even with a margin as slim as 1% or less, and large volume insured storage can be attained for just a fraction of a percent per year, even with today's price of gold. At a higher gold price, those same margins will be profitable for smaller operations. But even more remarkable, when you think about it in the proper future context, is how gold is perfectly geared to appreciate at just the right rate. Let's call it the Goldilocks principle. Fast enough to give us "an enduring, tradable wealth asset that places our footing in life on equal ground with the giants around us,", but not too fast, so that it will never attract the "hot money" flow of the investors.

Perpetual Appreciation (The Focal Point Effect)

"Truly, as gold is once more used as "wealth money", this action will again impart an unlimited value for gold in use. The more we built and created, the greater the gold value must always be in the future. …In this context, its demand will remain, as always, infinite." –FOA

"Furthermore, the price of gold is arbitrary. This means that gold can go as high as the people of Earth want to take it without EVER exceeding objective valuations by common metrics like earnings, interest or the sum value of its component elements... One of the most common criticisms of gold's use as an investment is that it cannot be valued the way stocks, bonds and real estate can… But if we invert this argument then gold can never be OVERvalued either, whilst those other things can..."

I want to discuss this concept a little more, because my use of the word "arbitrary" confused certain people. In this context, "arbitrary" does not mean random or irrational, but rather more like seemingly random or seemingly irrational, kind of like the price of "Balloon Dog (Orange)". It refers to the price being more subjective than objective, determined by individual preference and demand rather than by "rational metrics" or comparison to the price of other things.

1: depending on individual discretion (as of a judge) and not fixed by law

3a : based on or determined by individual preference or convenience rather than by necessity or the intrinsic nature of something

b : existing or coming about seemingly at random…

This is precisely what sets gold apart from the world of investments and puts it more in league with high-end collectibles as a store of value. All things other than gold (and other stores of value) have relative values which are tied to each other by common metrics which cannot be applied to gold. The price of gold is "arbitrary" relative to the common metrics which price everything else, therefore when gold's function changes in Freegold, its new price (priced in other goods and services) will shock and awe anyone who didn't understand the "arbitrary" nature of the price of gold.

The price of anything is actually its relative value compared to everything else. That's what price is. It is relative value. FOA wrote, "Money in its purest form is a mental association of values in trade… the value is in your association abilities." This is where gold is distinct, disconnected from everything else. Not today. Today gold trades as if it is a commodity like oil or other metals, with a price driven by that association. But this commodity association is only in the minds of Another's "modern day middle of the spectrum". When "Street Gold" and "Paper Gold" part ways, "the dollar will find "no problem" with $30,000 gold", and people will say "why did noone see this sooner"?

Well, you can see it sooner, and that's why I'm discussing the concept of "arbitrary" pricing, from a $490,000 card table to a $58,405,000 12-foot-tall metal balloon dog, to a $104,500,000 Andy Warhol painting. But what about after gold is revalued and functioning as a true store of value? Can we expect it to continue appreciating into perpetuity? Yes, of course we can!

Now, I need to briefly mention the concepts of marginal utility and substitution since I used the terms subjective and objective above. All prices (relative values) are essentially subjective in that they are derived from demand related to the primary utility of the item. Think buggy whips versus umbrellas. An umbrella still has a use, and therefore demand, while a buggy whip does not. But the prices of gold and other stores of value are more subjective than other things, and the prices of other things are more objective than stores of value. And this relative measure of "objectivity" (as I'm calling it) comes from the concepts of marginal utility and substitution.

Marginal utility means that, for things in which their primary utility is the service they render in their specific form, like a table, the value derived from demand for this utility declines at the margin. How many tables does one man need? At some point he will have enough tables, and at that point, his demand for another well-crafted and nice-looking flat surface with four legs will decline. In economics, this is called the law of diminishing marginal utility, and it applies nearly all utility functions except the store-of-value function. Shoes, in Imelda Marcos' case, might be an exception to the rule.

The substitution effect is the idea that as the price (relative value) of something rises, it will eventually be replaced by a less costly alternative that renders the same or similar service. These two concepts are essentially limiting factors in the relative values of everything other than the very best store-of-value collectibles.

I'm getting into some heavily-conceptual territory here, so please bear with me. I want you to think about the regression (historical effectiveness), network and focal point effects as they relate to the very best artworks in the world. Being one of the very "best of the best" is an emergent property, one that can only be identified in hindsight. In fact, picking unique individual pieces of art is indeed a bit of a gamble. Who's to say that "Balloon Dog (Orange)" (or any of the colors for that matter) will turn out to be a good store of value 40 years from now? Will it stand the test of time? I have no idea, but I wouldn't bet my own money on it!

What would it mean for "Balloon Dog (Orange)" to stand the test of time, or not? Is it about price appreciation? As I said above, you really have to think like a Giant to see that it is not about price appreciation. I realize this is a difficult concept for a Shrimp to even consider, but as I said, Giants seek and hold these kinds of items because of the confidence engendered by the regression, network and focal point effects that, when needed, they will be able to find a buyer ready to pay the highest price which can possibly be attained in the market at that time.

They don't hold it because it appreciates. It appreciates because they hold it. Cause and effect. Perpetual appreciation is the effect, not the cause. The cause can be traced to the regression, network and focal point effects.

Of course not every piece of artwork that sells for $10, $50 or $100 million will be able to be resold years later for a profit. Only the "best of the best" will, and we'll only know for sure which ones those are in hindsight, after the fact, after they go to auction. And yet, even though we can't know for sure, we can have a high degree of confidence about some of them. How much do you think the Mona Lisa is worth?

___________

What do you think? Is low but steady perpetual appreciation in real terms even possible? Someone asked me recently: "FOFOA, I've heard many people say that interest is evil, and then they use the old "if you deposited $100 earning interest over the last 2000 years it would be enough money to buy the world. So to play devil's advocate if gold rises in purchasing power over time wouldn't it create a similar problem to compound interest. Theoretically 5000 years from now one ounce of gold could buy the whole world and whatnot?"

This is a good question, because for Westerners raised from birth to think of value in terms of nominal digits, compounding appreciation does seem to raise a red flag. But in digital terms, even theoretically, there's a difference between nominal interest and interest in real terms, or real interest. In order to "own the world" you'd have to earn a compounding interest rate in real terms, and what time has revealed is that such nominal appreciation is always offset by a depreciating denominator.

Imagine you had a 2% inflation rate and you also earned 2% in compounding interest giving you perfectly stable purchasing power. As your compounding interest turns exponential, so too does your denominator (the numéraire) lose purchasing power. You can try an exercise on a simple Excel spread sheet.

Start with $100 in two columns. In the first column, depreciate the base unit by 2% per year. So 100*0.98 and reiterate that for 100 years. That will show you the decline in purchasing power of the base unit. Then in the second column, give yourself 2% interest for 100 years. 100*1.02. This will show you the compounding principle. After 100 years, your base unit will only be worth 13.26% of what it was the first year, and your compound interest savings account will have $724.46 in it. You can run iterations to infinity if you want, but as your nominal balance approaches infinity, your base unit value will approach zero.

If you take away the depreciating denominator, then yes, your purchasing power will eventually approach infinity. This doesn't happen in the real world, but, amazingly, perpetual appreciation in real terms is still possible with a true focal point store of value.

The Mona Lisa is quite possibly the most valued painting in the world, even though it has never been on the market in the 500 years since it was painted, and probably never will be. (Notice I used the subjective word "valued" rather than the more objective word "valuable", because value is a subjective attribute, especially in items whose primary purpose is the retention of said subjective attribute over time. Which is kind of the whole point of this post, but I digress.) It is certainly the best known, most visited and most written about piece of art in the world, great focal point features. It is considered a national treasure in France, although in 1911 an Italian tried to steal it back for Italy. How much the Mona Lisa would fetch on the open market is impossible to know, but we can probably guess the bare minimum.

The most expensive painting ever sold was a Cézanne painted in 1893 which sold to the State of Qatar in 2011 for around $300 million. While the Mona Lisa has never been on the market, it did go on tour in 1962 at which time it was assessed for insurance purposes at $100 million. According to Wikipedia, $100M in 1962 would be $760M today, "making it, in practice, by far the most valued painting in the world."

In order to calculate its real rate of appreciation, compounded annually, we must guess at a starting value for the painting. As I have said, the focal point effect is an emergent property revealed over time. So while Leonardo da Vinci was very famous in his day, we shouldn't assume an overly-high initial valuation. The Mona Lisa is believed to have been a commissioned portrait which was never delivered, went unfinished for more than a decade, and remained in da Vinci's possession until his death in 1519.

If it had been worth millions (in today's dollars) on the art market of the time, you would think he might have sold it, or at least finished it earlier. An amount was supposedly paid for the painting by the King of France after da Vinci's death, but it is unclear what the modern equivalent of that payment would be. It might have been the equivalent of $100,000 or more. So let's err on the high side and say that the Mona Lisa might have sold for as much as $500,000 in modern terms had it been auctioned off upon completion. That's probably too high, but it will suffice for our purpose.

We can use a compound interest calculator to figure out the rate of appreciation for something that appreciated in value from $500,000 to $760,000,000 over 500 years, and that rate is 1.47% per year, compounded annually. That's real, not nominal, appreciation. And that's the low but steady perpetual appreciation in real terms that I'm talking about. It comes from the focal point effect. Obviously not everything can appreciate in that way, but the focal point can. (BTW, if we start the Mona Lisa at $50K and appreciate it up to $1B over 500 years, which is probably more realistic, that's still only 2% annual appreciation.)

Like I said, I'm deep in conceptual territory here, so, again, please bear with me. I want you to think about all of the gold in the world as a single unit or mass. And as God is to Leonardo da Vinci, so gold is to the Mona Lisa. Gold is God's "Mona Lisa". And as you'd expect, coming from God, gold has many features which make it almost infinitely better than the Mona Lisa.

To begin with, while the Mona Lisa has 500 years of emergent focal point effect under her belt, gold has at least 5,000 years. Gold is divisible without losing value. If we cut up the Mona Lisa into 760,000 pieces, do you think we could sell each piece for a thousand dollars? And even if we could, would they retain that value over the long run? Gold is much more durable than the Mona Lisa, and therefore much more economical to store and transport. The transaction cost of gold is also much more economical. If you could buy the Mona Lisa through Christie's today, their commission would be $91M, but you could buy $760M in gold for a transaction cost of less than $8M.

Get the point yet? Gold has better fundamentals for fulfilling demand related to the service it renders as a "real thing store of value" than anything else. Those fundamentals are the regression effect (a longer history than anything else), the network effect (more Giants and "third world no ones" than anything else) and the focal point effect (only real gold is "as good as gold"). That doesn't mean it should appreciate at a higher rate than the Mona Lisa, however, because remember that appreciation is an effect of these fundamentals, not the cause.

The cause is the confidence in those who possess (and seek) physical gold, confidence engendered by the fundamentals, that, when needed, they will be able to find a buyer ready to pay the highest price which can possibly be attained on the market at that time. That confidence is the cause, and perpetual appreciation is the effect. But I think you'll need to think like a Giant in order for that to really sink in.

Giants, who think this way, indeed, are the foundational base of gold's value. Like the very best-of-the-best works of art, Giants have every reason to accumulate more, keep what they already have, and no reason to ever sell. It is quite simply the divisibility of gold that will "place our footing in life on equal ground with the giants around us."

There are several simpler arguments for perpetual appreciation that I could have made much more easily, like FOA's quote at the top of this section: "The more we built and created, the greater the gold value must always be in the future." This is physical plane appreciation we're talking about. That's what "real" means: gold appreciating against other real things. I could have discussed the changes in gold mining that revaluation will induce, and how public sector gold actions, including mining, will essentially be monetary plane operations with minimal effect on physical plane appreciation.

I could have discussed growth rates, stock to flow ratio and how revaluation in real terms eliminates prior volatility in real terms because it increases relative "mass", and therefore inertia, in both currency and relative value terms. I could have discussed the wide variety of investment options that will keep "hot money" away from gold, delineating, once and for all, savers from investors, traders and speculators. But I wanted to tackle the most difficult argument I could think of—the "infinitely divisible God's Mona Lisa" concept. So how did I do? Does it work for you?

___________

Even with all of the towel-throwing we've seen over the last two years since the bull run ended, it's important to remember that for every seller there must be a buyer. Every last piece of gold on this planet is equitably owned by someone, even if it feels like no one wants gold anymore.

"Do you think that value has been lost by holding physical gold all these years?

If the answer is yes, you are wrong! I tell you now, it's all in your perception of what is value and what is real. Gold has been increasing in value since the early 90s and doing it at a rate much higher than any other investment. Cannot see this? Hear me now, what the wealthy and powerful know: "real value does not have to always be stated or converted thruout time. It need only be priced once during the experience of life, that will be much more than enough!" –ANOTHER

Revaluation is a one-off event. The reason for seeking and holding gold after the revaluation will not be the anticipation of another revaluation. For the very strongest hands which form the foundation of gold's high value, the reason won't even be perpetual appreciation. The fundamental reason for seeking and holding gold after the revaluation will be the confidence that, when needed, anyone anywhere will be able to find a buyer ready to pay the highest price that can possibly be attained on the market at that time. Of course, some people, who are today holding gold only for a revaluation windfall, will immediately cash in that lottery ticket. One such person just wrote this in the comments under the last post:

"To wake up one morning and find that I’m freegold multi-millionaire would be like a kid waking up Christmas morning, I can’t wait."

But I wonder how many weak-handed Western shrimps with this mindset will actually be among the strong-handed Giants and "third world no ones" that constitute the vast majority of equitable owners when the time comes. I know a lot of people who have already thrown in the towel, so I suppose it depends on when it happens, at $1,000, at $800, or at $250. I suspect there could be a lot fewer than we might think.

What we see right now is the last bits of physical gold gradually working their way into stronger and stronger hands as the price declines, just like the best-of-the-best artworks which, once they reach the strongest hands, never hit the market again. Just something to think about as you hear more and more Western investors throwing in the towel on physical gold. Wow, what timing!

Revaluation

"Yet, through it all, the revaluation must come as gold will return as money to represent all of this wealth many times over. For truly, all modern wealth will be directly or indirectly denominated in gold as our dollar reserve fails. To this end, the physical gold holder will stand "one step in wealth" ahead of every worldly paper trader." –FOA

"The removal of the political "world dollar settlement" price of gold will revalue this asset in terms that noone of "western thinking" can understand." –ANOTHER

"A poster on Kitco (I think his handle was AllenUSA) once did a superb job of explaining the dynamics of oil pricing during a currency collapse and gold revaluation." –FOA

"Both gold and currencies are traded with perceived future value in mind. Especially gold that is known to be revalued later." –FOA

"I fully well expect my wealth holdings to not grow one bit over the next twenty years!!!!!! But, I do expect the world markets to evolve and revalue my assets, showing their true worth. No, not near gold, not almost gold, not poor man's gold, not gold in the ground or other paper gold,,,,,,,,,,,, just plain old gold in the hand. An asset that will out perform every other holding in the times to come.

--------- The wealth of ages; a lifetime of work kept in a savings from our past. --------" –FOA

"Yet few considered the true ramifications if countries suddenly revalue gold not as money, but as a world reserve asset! We approach this dynamic today as world dollar debt has reached its limit. Exciting times for those that "walk in the footsteps of giants", awful times for those that have invested in the gold industry. It's not too late to change course and sail with the wind. With the direction of someone that understands, I have done just that! With the wind...........we are on the road now!!!" –FOA

"From this stance we can understand why many have viewed gold as a riskless holding that will be revalued. If it was part of your mix, the transition would always make up for any return lost from not holding other assets. Indeed, it is the very ultimate in a super leveraged investment. No other currency today could expect a 1,000% to 10,000% rise in value against the dollar, none." –FOA

"The current "paper gold market" is not a physical gold trading arena, as many here have observed and discussed. Truly, in every sense, it is a "currency market" as contracts are settled in the prevailing "currency values" of gold. It is through this process, that gold is purchased "as a stated value in currency terms", not in physical terms. It is known, that a switch to trading of gold to "physical terms" of the same volume as today, would not only bring a huge revaluation in price, it would also destroy the market." –ANOTHER

"If all the gold held by earth were placed in the hands as money, it would be used to revalue every "real thing" at a fair price. A tiny fraction of gold would buy much production of goods and services, on a basis equal for all men, not as a debt for later settlement, as currencies are now!" –ANOTHER

"Once fully understood, I think most would then agree with its inevitable outcome. Indeed, a "free gold market", based only on physical holdings would impact the world economic system unlike anything seen before it. And Yes, it's impact on the relative value of gold will make that metal the monetary wealth investment for the next thousand years!" –FOA

After all these days,,, did Another "time" the gold market correctly? No, not for traders he didn't! But, then again, his whole message and proposition was never for a trader's mindset or time frame. Indeed, his direction was for simple savers, like you and me. As a conservative group, our holdings represent the most long lasting, stable assets that presently exist. Such assets collected over a lifetime should not be lost to a world gone mad! Truly, Another's thoughts represent the values held in the old world. For many these are in competition for our hearts against the current façade of economic reality.

We now understand how short-lived the current misconception of money must be. Other fast paced modern investors have accepted that "money was never wealth" and paper currencies need not be real things to represent their savings. Lost on these "educated of the Western world" is the knowledge that "wealth in the form of real things" was the first thing humans traded. It was only later that someone labelled these things as money. As a people, we once knew the special value of gold and held it beside our other tradable property. We held this gold more dearly because it made the best form of "tradable" wealth. In this context, its demand will remain, as always, infinite. It mattered not if one had one ounce or one million ounces, as gold money was/is but a representation of the real tradable wealth you saved over a lifetime of work. How far must modern gold now climb as it is reintroduced to the world as a new "tradable money wealth"? As far as the unlimited efforts of humanity!

Truly, as gold is once more used as "wealth money", this action will again impart an unlimited value for gold in use. The more we built and created, the greater the gold value must always be in the future. Neither time or new ideas have changed human nature as it seeks to run from the modern uses and valuations of "IOU" wealth. A wealth that was never as great as the dollar said it was. As a system it could never represent a lasting "wealth of nations" as held in the account of "common man". Gold will come pouring in to fill this void.

This coming new level of value for gold is the "proposition" Another presents. A concept that is now being embraced as "something new" for a failing economic system now based upon an over leveraged world reserve currency! Truly, the old ways will not fail those that see through our modern money fog. Another once put it somewhat this way; Nothing has changed our need for real things as tradable items. And this earth is still round my friends. As I hold my gold for the money it is, traders will work all these markets as they must. With the speed of light they now circle the earth, only to find their future as but one step behind me!

Yes, Another once said that. Differently of course, but an incredible bit of insight it remains. I also accept that most "physical gold" savers will find themselves "many steps" ahead of the "Western trading community" as this plays out. This "long term gold accumulation" proposition was given some time ago, to induce conservative people to begin saving gold "now". At any dollar price, be it $600 or $10! Such direction was given in the face of unprecedented choices from where someone could make fortunes using our modern vehicles. Yet, through it all, the revaluation must come as gold will return as money to represent all of this wealth many times over. For truly, all modern wealth will be directly or indirectly denominated in gold as our dollar reserve fails. To this end, the physical gold holder will stand "one step in wealth" ahead of every worldly paper trader. Whether they trade paper gold stocks or dow stocks, real estate deeds or CDs, in the end their paper winnings will compete with the spoils of all others of "Western thought". These "non physical owners" will seek to buy what gold they can at a price many will refuse to understand. If one made a million by paper investing, he will buy no more than a million in gold. Still, for every new buyer that wishes to escape the old paper world there will be the lowly physical buyer from the past who will already possess two million in gold.

You see, there is a world of difference between saving real money as a "wealth of ages" and trying to trade this world's "paper derivatives". The lasting wealth of physical gold does not have to be "converted" into real things prior to a currencies destruction. It already represents the new holding everyone will want. The coming "Western" economic dislocation will devastate all forms of assets that are held in "contract ownership". Be they stocks (most gold stocks included), bonds, businesses or savings accounts, etc.; the loss of a major currency will consume most of the equity these paper items represent. It has happened with every currency ever created and will happen again with our dollars.

So, the next time you read that someone lost their "bet on gold", remember, they lost because they made the wrong bet. Only a "bet" of "buying physical" over time represents the FOA/A true position.

Another recently said:

"The time? These years be right for ones who save gold. One good ear knows meaning of wind in trees. The leaves come down as seasons change. Fools see falling price of gold as "death of tree", they chase its price as leaves on the ground. Know you all, it is the season that has died.

Time will prove all things. Ones of simple thought, such as I will save the wood, not the leaf as they buy the gold, not the price! Thank You Another

I will be posting and replying this weekend.

Thanks
FOA

Freegold

What is coming isn't merely a simple correction of imbalances that may, on the surface, appear to be the result of perceived monetary "sins" of the last hundred years, like the creation of the Fed in 1913, the 1922 Genoa Conference, FDR's 1933 gold confiscation and the 1971 Nixon shock. No, it's much deeper, much more mind-blowing, and totally inevitable.

Freegold is the emergence of a new monetary paradigm that has no precedent, certainly not in modernity, and probably not in all of recorded monetary history. It's a brand new idea, ironically with its roots in ancient history, whose time has simply come.

So, while it is true, as gold bugs would have it, that gold never really left the monetary realm, despite its official change in status, one needs to understand that physical gold's role going forward will, in effect, be the result of a shift in consciousness that, without engaging in hyperbole, might be likened to the evolution in understanding about what the universe consisted of that transpired after Einstein introduced the world to The Theory of Relativity. Money's functions will, like the atom, be split, and the world will not be the same afterwards. (Hat tip Edwardo ;)

Seasons Change, Leaves Die… and so do Systems

"These years be right for ones who save gold. One good ear knows meaning of wind in trees. The leaves come down as seasons change. Fools see falling price of gold as "death of tree", they chase its price as leaves on the ground. Know you all, it is the season that has died."

Thursday, December 5, 2013

Beware of fake gold being sold on eBay. I received this email from a reader yesterday:

Hi FOFOA,

I purchase the vast majority of my gold coins and (in-assay only) bars on eBay. I have had much success. eBay buyer protection has saved my butt on occasion, not just for gold purchases. I authenticate every coin I buy. For every purchase, regardless of source, I use a Fisch for Eagles & Krugerrands and a jeweler's scale and calipers for other coins, plus a detailed visual comparison to known-genuine coins (and bars). Anyway...

About a year ago I purchased a 1/10 oz. gold Philharmonic (10 euro). It was an obvious counterfeit. When I reported this to eBay it stirred up a brief hornet's nest: there were other buyers who got taken...they actually traced discovery back to me and thanked me. I remember someone asked you, a year or so ago, whether forgers would consider counterfeiting small gold coins. Answer: Yup!

But what happened earlier this week has, I believe, the potential to compromise the integrity of the slabbed coins certified by the major numismatic coin grading companies. I, for one, will never again knowingly purchase a slabbed coin. If I can't personally authenticate the actual coin (per the above) I don't want it. I purchased two generic 1/4 Krugerrands from a seller with 100% positive feedback (mostly small, non-gold transactions). The seller also sold at least 7 other 1/4 Krugerrands (I watched). The seller stated the coins were located in California. A few days later I received the tracking information: the shipment originated in Shenzhen, China. Hmmm! On Monday (12/2) I received the coins. They were NGC slabbed:

Wow! NGC certified proof gold coins a great price! To the casual observer, everything would look fine. Except, they are counterfeits! The obverse and reverse sides are supposed to be perfectly aligned. These coins were offset about 20 degrees (I could tell based on prong locations). Ooops! Then I examined both coins under 5X magnification next to a known-genuine 1/4 Krugerrand: there were many engraving quality discrepancies, especially with the border engraving shapes and overall lettering crispness and shapes. Bummer! I also compared the NGC slab to the website photo and another NGC slabbed coin I owned. Results: the slab was either stolen or (more likely) an incredibly accurate forgery, including holograms. I could not discern any defects whatsoever. Very disturbing.

I then 'opened a case' with eBay buyer protection for both coins, describing what I had found, including the above links to the NGC website. That's when things started to get really interesting! The next day I received a message (for each coin) from eBay stating that the seller had agreed to provide a full refund when I returned the coins. Then, within an hour, I received another message (for each coin) from eBay stating that I would immediately receive a full refund with no strings attached, which was done. Then something happened that I have never experienced with eBay before. Everything about the purchases (purchase history and seller account information) completely disappeared (poof!), as if the transaction had never occurred and the seller never existed. Bizarre! So, as of now I have possession of two forged NGC proof 1/4 Krugerrands until someone (?) tells me what to do with them. In the meantime I will play some show-and-tell guessing games with friends.

I asked him a few questions and also if he could take pictures of the actual coins he received. Here are the pictures, front and back, which you can compare to the photos on the NGC website:

The most obvious difference is that the coins seem to have shifted orientation inside the fitting, which shouldn't happen. But more remarkably, it seems that the reverse side of the coins shifted more than the obverse. Imagine that!

And if you look closely at the labels, they are clearly not the same labels as in the pictures on the NGC website. Look at where the printing intersects the background watermark. Notice how the P on the real one just butts up against the scale bowl, and on the fake one it overlaps the bowl. The M on the real one rests on the inside of the bowl, and on the fake it rest on the edge of the rim. Above the KR on the real one, there is a gap between the KR and the scale arm. On the fake there is no gap. And look at where the point of the 2 intersects the circle on the left.

Here is how he answered a few of my questions:

Were they advertised as slabbed? Did he include a picture of them?

"They were not advertised as slabbed. Just a generic (obverse) picture, which I can no longer access. I was surprised and very briefly (very briefly!) pleased that that they were slabbed...I paid $319 for each (including S&H). He had listed 3 at that BIN price; one had sold, so I bought the other two. He advertised later coins (3 at a time) at $329 BIN. I tried to buy more, but for (again) some strange reason I never encountered before on eBay, I was not allowed to buy any more for at least 10 days...the message said only a single purchase of up to 3 coins/buyer allowed per 10 days. Very strange."

Was the 3 coin limit imposed by the seller or by eBay? And was the limit apparent before you bought your first coin, or only when you tried to buy more?

"I don't know who imposed it or how. I did not know about the limit until I tried to make the second purchase (I tried again over several days to see it it was real...yup.)"

Did the seller appear to be an individual or a business?

"The seller is an individual (I even have his name & address in California). I have not tried to contact him. I don't know what would happen if I did. I'll let eBay worry about him."

What advice would you offer for people shopping for gold on eBay?

"My advice for buying coins from anyone, not just on eBay...immediately authenticate your purchases like I described earlier. For eBay, 'open a case' with Buyer Protection immediately for any perceived irregularities. Stay clear of slabbed coins unless you have the necessary expertise to evaluate them, since they cannot be weighed and measured.

eBay is quite diligent about tracking down forgeries, especially with regard to precious metals. I had several discussions with their precious metals fraud team after I discovered the fake 1/10 Philharmonic I told you about. They traced all the eBay purchases of that batch of coins (~200; some were resold several times) back to the original seller, shut down open listings, and contacted buyers. I think everyone got their money back. As I said, buyers traced discovery back to me and I got thank you's for identifying the fakes. What really surprises me is that so many buyers didn't realize the coins were poor quality fakes...they only weighed 2.4 grams. Scary."

I have always advised people against buying gold on eBay, and I have never done so myself. Stories about fakes originating in China and sold on eBay have been around for years. My advice is to buy your gold from a reputable dealer. If possible, I prefer to buy in person from a local dealer who has been in business for a long time, but I have also had good experiences with APMEX.

I also think that coin shows are a great place to buy bullion coins. I can usually negotiate a good deal, often better than what's offered online, and meet lots of local dealers at the same time. It's also an easy way to swap your silver for gold! ;D Here are a couple of websites to help you find coin shows scheduled in your area:

As for slabbed and graded coins, I prefer to avoid them, for precisely the reasons above. I do have a few, but only because that was all my local dealer had at the time, and he sold them to me at the bullion price.

Tuesday, November 5, 2013

This post is my replies to two reader emails. The first one was to "Victory", one day after my Gold as a FOREX Currency post went up. And the second one was to "Burningfiat" on Friday.

Hello Victory,

"... My thinking is this, won't the end of $ support be clearly visible in the currency exchange rate? Isn't that where the rubber meets the road, there really should be no guesswork needed. The US is a perpetual net exporter of dollars and has long ago hyper-inflated…"

There is definitely a glut of dollars right now. In September the Fed announced its new "reverse-repo" operations. There is, of course, a lot of debate about what those are really about, but I think it is obvious that they are to mop up the glut of dollars and raise short term interest rates in money markets and t-bills. The Fed even said so. They said that these operations will raise overnight rates in the money markets so that lenders can actually earn some interest.

When there's a glut of dollars, it's hard for banks (who create dollars) or money markets (who auction existing dollars) to make money on interest because there's so much competition for the limited pool of borrowers. Too many dollars drives interest rates to zero and even negative in some cases. So the Fed is actually competing against real organic borrowers for its own liabilities. The Fed will pay you to lend your extra dollars back to the Fed, even though what the Fed is "borrowing" are its own liabilities. So the Fed is creating synthetic demand for its own product to drive overnight and short term interest rates higher.

You're looking for a crash in the USDX to indicate the imminent end, but I have always expected a spike in the dollar, and I think Another expected that as well. I have written in the past that we could even see the USDX spike (very quickly mind you, not a slow rise) to something like 150.

What we see right now is big money piling into short duration, even overnight, assets. To escape, that money will have to pass though dollars once again. Where the rubber meets the road, in my opinion, is not anywhere inside the monetary plane. Instead, it is where the monetary plane intersects the physical plane, and that is in prices, the prices of real physical things, the price of physical gold and the price of (primarily imported) necessities. That's where I expect to see the break, in one of those two places: the LBMA or a real price jump in necessities. Whichever one comes first, I think it will quickly cause the second one to follow.

What that means, practically, is that either physical gold goes into hiding first, or there's a sudden devaluation of the dollar against the physical plane, meaning necessities, especially those necessities needed by the USG which must be imported. When that happens, the USG will print whatever is needed to keep its imported necessities flowing in under the aegis of national defense. Actual hyperinflation will follow.

When this happens, or a top level disruption within the LBMA, all that money piled into short duration assets will panic out and bid for dollars which it needs in order to pile into anything else. This will briefly drive the dollar way up on the USDX. It may even happen before you know what's happening, because big money tends to panic before small money even knows there's something to panic about. Remember this story from Unambiguous Wealth 2?

"Compare these big money folks to the average guy who rides the bus. You miss a bus, so what? It's inconvenient but another bus will come. It takes a long time to sink in that another bus isn't coming. It's not until there is such a big crowd waiting at the bus stop for the next bus that people start thinking "even if a bus comes there are too many people to fit on one bus." In that mindset the surest way to cause a riot is to send one bus i.e., not enough buses. You have to fight to get to the front of the queue. This is a bank run mentality.

And this is a key difference between the average guy and the big money. Big money isn't used to being kept waiting. Big money owns the "bus company". They know the buses aren't going to run before the little guy. They panic early. There was an electronic bank run around the time of the Lehman collapse. That was one of the reasons why governments around the world stepped in with fresh deposit guarantees. But there were no lines outside the banks to alert the average guy to what the Giants were up to.

Right now gold is $1,712 per ounce. If you have $200,000 in ambiguous claims floating through system-space, your account is right now worth 116 one-ounce gold coins of unambiguous wealth. But here's the thing. You are never going to beat the big money to that panic button. There are enough gold coins on the market right now that you could get your 116 of them without affecting the price. But if you're waiting for the first signs of panic, you're not going to get anywhere near 116. You'll be lucky to get six or seven.

There's only one way to beat the Giants to the gold, and that is to run in front of them."

Apply this reasoning to the signals you are watching. Even though you aren't waiting to buy gold coins at the last minute, you are still looking for signs that systemic transition is imminent. So what you want to look for are signs that big money is panicking, not the signs that you think will cause big money to panic. Because chances are that the really big money will see those signs before you do, and panic before you even know they are there. Therefore, signs that you think should be making big money panic, when it's not panicking, are probably the wrong signs. See?

In the comments section, it often seems like the Freegold holy grail is to be able to predict the proximate cause, and therefore get some advance warning, and therefore be the first to make a correct timing call on Freegold, even if it's only by days. But if you follow my reasoning, then it is most likely a waste of time trying to gain some advance warning. The advance warning is in the logic, and in the A/FOA archives. And the holy grail is simply buying physical gold now, before it happens. That alone will make anyone look like a genius in hindsight.

Some people look for rising short term interest rates as a sign of systemic stress, while others look for rates to fall to zero or below. Some look for a falling DX while others look for a spike. That's all monetary plane stuff, and not where the rubber truly meets the road. As I said, the Fed is trying to levitate short term rates right now, so why would rising rates indicate stress? To me they indicate that the Fed has sufficient control over the monetary plane, which I kind of assumed it did. What it has no control over is where the monetary plane intersects the physical plane.

"So my question is really this, until we see the $ drop rapidly on the FX market don't we know that official support from someone besides the USG is still in full effect. And the corollary that FG will not be imminent until this support is withdrawn, which we would see immediately in the FX market as a $ devaluation?"

We could see a sudden drop in the USD versus other currencies in the FX market, or we could see a spike. But I think we will eventually see some sudden, unexpected and highly unusual volatility. That's what I would watch for if you're one who likes to watch the pot, waiting for the water to boil. Watch for unusual and extreme volatility, because that should be what we see when the monetary plane comes unhinged from the physical plane. And don't forget the concept that there can be a head-fake right before a phase transition, a sudden and major move in an unexpected direction.

For me, I already have the advance warning in the logic and the A/FOA archives. I try not to watch the pot, but instead to explain the logic to others, because I think that's better than trying to predict how the monetary plane markets will behave at that moment when the physical plane lets go.

Sincerely,
FOFOA

Hi FOFOA,

Hope all is well!

Do you have an opinion of the latest strange GLD inventory update behaviour?

Could it be a sign of rumblings further down in the machine room? Or do you really think it's all just meaningless pot watching? :)

/BF

Hello BF,

I certainly think it is interesting, but the short-term variations we see don't change my opinion of what is happening behind the scenes. I think the consistent drain this year is a sign of rumblings further down in the machine room, but I find it hard to believe that the reporting anomalies are reverberations from the same thing that is causing the drain. More likely, I think, there is probably some explanation for the reporting anomalies that we just don't know about, something that we haven't even considered.

The indisputable story is that GLD has lost 36% of its inventory, 487 tonnes in 10 ½ months. Title to that gold was transferred to someone. The only question that matters is whether it was transferred into BB reserves (the plenitude view) or into private ownership (my view, and obviously the correct view ;). That's more than 46 tonnes per month.

The BBs probably have at least twice that much coming in through mining and scrap (just a guess), so let's imagine they have 100 tonnes coming in each month. The outflow is obviously higher than the inflow, but the pressure is widely distributed across the LBMA. So the rumblings in the machine room are widely distributed and therefore isolated from what we see in the reservoir drain reporting. GLD is where the buck stops, where they obtain that shortfall of incoming gold, but it is not likely going to a specific buyer. More likely, it is simply restocking the subterranean stream.

The point is, I wouldn't expect the underlying cause of the drain to transfer "short term vibrations" into the daily reporting of the drain, I only expect it to show up in the greater trend. Therefore I think it is more likely that there must be a more mundane explanation for the reporting anomalies that we see, something we simply don't know about and therefore haven't even considered. That's the way I apply Occam's razor to a situation like this.

I expect the short-term machinations of the system to appear outwardly normal right up until the moment the pistons seize up and the whole machine comes to a grinding halt. That's the way these things usually seem to end. So I expect that could happen at any moment, without visible warning signs. In hindsight, I think we'll realize that OBA was right, it was just a hair's breadth away. But watching the pot can make even a hair's breadth feel like an eternity from the watcher's perspective.

So yes, it's interesting, but Occam's razor tells me that we are most likely watching the effects of some mundane cause we are not aware of while "superstitiously" trying to attribute those effects to the greater cause which is clearly obvious in the long-term trend. That's fine, and it is human nature to do so, but at what cost? The cost is that a hair's breadth starts feeling like an eternity, and some people can't handle that feeling and end up throwing in the towel.

Have you noticed how many people that have only been following my blog for a year or so eventually start making emotion-based predictions that Freegold must be 5, 10, or 20 years away? I have been at this for more than five years, and I still have the same view I had in 2008, that it could happen at any moment and each moment that passes brings us one moment closer. In fact, I think it must be almost here right now! And I think the reason I am able to maintain that view is that I have never been a pot watcher. I have always paid more attention to FOA's logic and the long-term trend than to the short-term vibrations.

The long-term trend is that the commodity bull/dollar bear market ended more than a year ago, even though dollar inflation *policy* is firmly in place. Shortly after that, the GLD drain began. And shortly after that, support for "foreign dollar settlement with CB storage" reversed and began declining. This is very close to what FOA said in one of his last posts: "The game is to let the US economy suffer from its own bloated expansion by moving slowly away from supporting foreign dollar settlement with CB storage. This is more than enough to end the dollar's timeline as we are already stretched to the leverage limit. They know that [the Fed] has but one policy to use and that will be super printing."

Anyway, keep up the great work with your auto-pot-watching app! I do enjoy the short-term show, even if I don't put much stock in it. ;D

Friday, October 18, 2013

Another gold writer emailed me the other day with a few questions about my take on the apparent disconnect between the gold price action this year and "physical gold's obvious fundamentals." I explained to him how the POG (price of gold) is thoroughly and utterly disconnected from the physical segment of the gold market today. I said that any increase in physical demand (due to physical gold's obvious fundamentals) does not, cannot, drive the price higher today. It does one thing and one thing only, it stresses the current gold market structure.

The reason, I said, is that physical gold's fundamentals have nothing to do with "today's gold market." Today's gold market is "majority-owned" by gold trading as an electronic FOREX currency, which has almost nothing to do with the physical side of the market. That exchange by itself would probably make a good post, but this one is all about his primary follow-up question, which was:

"The area where I’m still hazy is the gold as a FOREX currency."

The following was my reply to his question, which I wrote in great detail with the intention of turning it into a post because it's something I haven't seen any other gold writers even acknowledge, let alone factor into their POG analysis:

As you well know, the POG rose in the 70s, but then in the 80s and 90s it fell from about $500 down to $250. During the 80s and 90s is when the CBs started leasing gold, or at least lending in gold-ounce-denominated units (lending their good name as Another put it: "Understand, they only lend their good name on paper, not the gold itself"), so that the bullion banks could help the mines hedge against the declining POG and not only keep producing, but actually increase production. From 1985 to 2000, global gold mine production increased from 50 million ounces to 82 million ounces per year, even as the POG was halved.

Checkmate is a good post for this wide view, or just watch this video by Freegoldtube, from the bottom of Checkmate, which has some relevant quotes from FOA:

This gold leasing/forward hedging started around the same time as Barrick switched focus from oil and gas to gold, around 1983, but by the mid- to late-90s it was more than mines taking these gold-ounce-denominated loans. Hedge funds wanted in on the gold carry trade too.

Meanwhile, following the closing of the gold window in 1971, gold received its official ISO 4217 currency code: XAU. This happened in either 1973 or 1981 (I'll explain the uncertainty in a moment, but I assume it was 1973 although I don't have the 1973 list). Silver received its own currency code, XAG, in 1983, platinum (XPT) in 1989 and palladium (XPD) in 1993. I mention these dates to show you how new all of this is. Mine forward hedging, CB gold lending, gold carry trade and metals trading alongside currencies on the FOREX. All very new.

Last year I emailed the currency ISO office in Switzerland to obtain this information. Here was my email and the reply I received:

Dear Sir,

I have a question about XAU (and the other commodity codes XAG, XPD, XPT). I understand that ISO 4217 was developed in 1973 and adopted a few years later. I also understand that SIX periodically publishes updates to the list, the latest being in 2008.

My question is: Was XAU on the list from the beginning in the 1970s, or was it added in one of the later published updates? And if so, what year was XAU added as a currency code for gold (as well as the other commodity codes)?

Lastly, if you could direct me to a copy of that historic publication in which XAU was added, that would be much appreciated!

Sincerely,
FOFOA

Dear Mr. FOFOA,

Thank you for your mail. Unfortunately we do not have a copy of the 1st edition of ISO 4217:1973. XAU was added either from the beginning in 1973 or later to the 2nd version in 1981. I attach the 2nd version for your information. [Click here to download the 2nd edition of ISO 4217:1981]

Everyone knows about the mine and hedge fund involvement in the gold carry trade in the 90s, but much less attention has been paid to gold's use as a currency in the foreign exchange market (the FOREX), which continues to this day. I'm sure you are aware of the massive size of the FOREX market compared to other markets, but here's what Wikipedia says about its size:

According to the Bank for International Settlements,[4] as of April 2010, average daily turnover in global foreign exchange markets is estimated at $3.98 trillion, a growth of approximately 20% over the $3.21 trillion daily volume as of April 2007. Some firms specializing on foreign exchange market had put the average daily turnover in excess of US$4 trillion.

"Daily volume" and "daily turnover" are confusing terms, because there are different ways they are estimated in different markets. Double counting, for example, is one potentially confusing factor. But I think that the sheer size of this market is what is most amazing, whether it is $2T, $4T or $8T per day changing hands, it still dwarfs other markets.

In January of 1997, the LBMA released its "daily clearing volume" for the gold market which was an astounding 30 million ounces or 930 tonnes per day. At the price of that time, that was about $10B per day. Today, thanks to the 2011 LBMA survey, we know that "total daily turnover" is about ten times "daily clearing volume", and that "spot" (as opposed to forwards, swaps, options and other derivatives) makes up 90% of that volume. That's the "gold spot market" today! About $100B daily turnover in January 1997, and $240B per day in 2011, the equivalent of 5,400 tonnes total, or 2,700 tonnes changing hands every day! And that's from 64% of the LBMA members reporting, so it's likely higher, especially once you add in non-LBMA (retail) FOREX trading.

For comparison, the annual flow from mining and scrap recycling is about 4,000 tonnes. That's annual. So the physical flow from mines and recycling compares to the LBMA spot market like this. About 16 tonnes per day in physical versus 2,700 tonnes per day in the "spot market". Now what could possibly constitute such an enormous "spot market"? FOREX trading.

The FOREX market is a $4T per day market including all currencies, and it looks like the "gold trading as a FOREX currency" portion of that market could be $240B at a minimum, possibly higher. That would make "paper gold" a full 6% of all currency trading in the world, including dollars, pounds, yen, euro and the rest of the 178 "currencies" with their own ISO 4217 codes. Think about that.

Amazingly, this was clear to some even in 1997. That's what spawned the Red Baron series, and I think the LBMA revelation was at least partly responsible for A/FOA showing up on the scene. Who knows, maybe Another was the one who leaked it to the London Financial Times! Here's a bit from My Candid View – Part 4:

Back during the London Gold Pool years (late 60s), physical demand did drive the price of gold up. And, perhaps in the late 70s and 80s and even into the mid-90s, Comex futures were more than just a side show in driving the price. But today I think it is clear that there's much more money chasing gold in the FOREX market than anywhere else. How else can we explain the volume in the LBMA survey? And I didn't come up with that explanation. It first appeared in 1997 right after the LBMA first revealed its tremendous clearing volume. Note that clearing volume was still shocking then, but it's also much smaller than total volume. From the Red Baron series circa Sept. 1997:

"The formidable volume of daily trading strongly resembles that of currency trading."

Now, currencies trade in pairs, like USDJPY or XAUEUR. The first in the pair is the "commodity" you are trading, and the second one is the "money" it is priced in—the denominator. So if you are long USDJPY, you are essentially long dollars and short yen. Earlier, you mentioned how it's easier to play the market from the short side when the price is falling, and I mentioned a conversation I had with FOREX Trader back in early June, which you hadn't seen.

Here is that conversation. It was about the implicit carry (interest rate differential) built into currency pairs and cleared overnight, possibly giving institutional money (like pension funds) a built-in "yield" as an additional incentive to short FOREX "gold" around May of this year. It was unusual enough that it caught his attention and he sent me an email:

FT: Hey FOFOA,

Nothing new on the wire to report from my end. But I did have an interesting note for you which I've been meaning to email about, unfortunately been very busy.

The note is that carry is kind of screwed up in the FX market. As a simple example, EURUSD shorts are paying carry. Also, XAUUSD and XAUEUR shorts are as well, at least for the last couple of weeks since we noticed here in the office. Relative to the other G10 carries available, especially if you don't include the comdolls (NZD/AUD/CAD), the rate available is pretty good ($16/$1,000,000/night) on a relative basis. About a quarter of what you get for an AUDUSD long and about 4 times what you'd get on a USDCHF long.

I am very certain that this carry (combined with the technical position of the charts) is incentive for a lot of traders to short the FX pairs on leverage, carry can be a major consideration when trading a levered position. For example, we pretty much never hold overnight positions in AUDUSD or AUDJPY.

FOFOA: Can you explain this a little more? Are you saying you earn a small "interest rate" when you short the euro or gold?

FT: Surely you have heard of the "carry trade" before? Let me explain it. Basically, the original investment thesis was essentially: given two "risk free" instruments, yielding differing interest rates, a trader purchases the instrument with the higher rate on leverage, and funds that position by shorting the instrument with the lower rate, at the same amount of leverage. This allows the trader to collect the "carry" or "swap", which is the overnight interest rate differential between the two instruments.

This concept is the cornerstone of almost all financial activity which occurs, as long as there is margin to borrow. Obviously a simple example would be the "bank spread", i.e. short 1-3Y Treasuries and long 10-30Y Treasuries.

Same applies, implicitly, in spot FX. If I am long $1,000,000 AUD and short $1,000,000 USD (i.e. long 1 AUDUSD contract) then each night as the banks roll over their intraday positions (squaring the books), I earn the interest rate differential (e.g. AUD LIBOR minus USD LIBOR divided by the number of trading days in that year) from whoever is on the short side of my long (through the broker). If I am short 1 AUDUSD contract then I must pay the differential to whoever is on the long side of my short.

Currently, both XAUUSD and XAUEUR shorts are paying carry. During a technical uptrend in an instrument like AUDUSD, this is a strong disincentive to short the instrument, as the trader must pay the differential to hold the position. A technical downtrend which pays carry on the other hand, gives incentive to the trader to short, the more leverage applied the higher the multiple applied to differential earned.

FOFOA: Thanks. Yes, I understand the basic carry trade (borrow one currency and sell it short to invest in a different, higher-yielding currency). Like the yen carry trade – borrow yen, sell them for dollars, use the dollars to buy Treasuries. Or the gold carry trade. Borrow in gold units, sell them for dollars, invest the dollars. You not only earn the interest differential but you also profit even more if the borrowed unit falls in value relative to the invested unit. And if enough people are doing this, the very act of doing it pushes down the borrowed unit. It's all great until it's not and everyone rushes to unwind the trade first. Sound right?

I just need to wrap my head around it in FOREX terms since I've never traded currency pairs.

FT: Yep that is exactly right, the only difference is that in spot FX, all of it is implicit, i.e. you don't need to go out and borrow to short, or invest the dollars in Treasuries, your short is part of the pair and you can earn the overnight rate directly.

FOFOA: One thing that was confusing me was your trader lingo: "the shorts are paying carry." To a non-trader who doesn't know the lingo, that could be taken both ways. As in "the short traders are having to pay the interest rate differential," or "short positions are now being paid the interest rate differential."

FT: Sorry about that! Never even occurred to me :P

I'm not sure I remember the last time trading XAUUSD paid carry in either direction, so I thought it was quite interesting. Obviously interest rates have had a jump over the last month, but I doubt if that's enough to account for this. It seems possible that the "interbank/overnight rate" for XAU has gone down significantly, driving up the rate differential?

The way I like to think of it is, if the US 10Y yield goes from 5% to 2.5%, then this indicates there has been strong demand from the market to lend 10Y money to the US Government.

So if the XAU "interbank/overnight rate" goes down, this indicates there is strong demand from the market to lend overnight money to ...???

FOFOA: Just to be clear on this "the shorts are paying carry", if I hold a $1M short position in XAUUSD overnight (I'm shorting gold because I think the $POG is going down), do I get paid $16? Or do I have to pay $16?

FT: Haha sorry, yes, to be clear, if you short XAUUSD then you get paid $16.

FOFOA: Thanks! And now who is paying me? Is it someone who holds a $1M long position in XAUUSD overnight? Does it now cost $16/night to bet on gold in the FOREX market?

FT: The person paying you is nominally your broker, but what's happening is everyone that has a long on XAUUSD is paying the broker and the broker is disbursing that accordingly to the shorts.

The differential is not nominally symmetrical because FX contracts are denominated in the "right hand" currency in the pair (in this case USD). So it actually costs $21 to bet on XAUUSD longs. Although I believe the differential expressed in percent should be symmetrical.

FOFOA: So it sounds like this is a big incentive to be short gold on the FOREX. How do you read this?

FT: I think it could potentially be a big incentive in the same way as I've been using AUDUSD as an example. Following a trend is nice because of the potential for capital gains. Following a trend which pays cashflow is obviously nicer. Leveraging a trend which pays cashflow, nicest of all, back up the truck.

MY SUMMARY: There is an unusual incentive right now to short gold on the FOREX. You get paid to do so, and it's the longs that are paying the shorts. This is separate from the capital gains made when gold actually goes down. So if/when gold goes down, the longs are not only taking capital losses, but they are paying the shorts an interest rate differential for the "privilege" of being long paper gold (overnight).

[Note: The above exchange was back in June, and it related roughly to the April-June timeframe. FOREX Trader brought this to my attention because he thought it was an unusual situation. He couldn't recall seeing the XAU shorts getting paid the carry before, although it's not something he normally pays attention to. Another FOREX trader also brought it to my attention that this would not necessarily be available to retail traders because fees, spreads and rates are often less-friendly to the traders at retail brokerages. That's why I specified institutional money at the top.]

Also in my last email, I mentioned that with "only" 3X leverage institutional money could turn that carry into a reasonable yield in a no-yield environment, to which you raised an eyebrow. Apparently, leverage is quite common in FOREX trading. Here is my comment about leverage back in June under my "Black Gold" post:

Hello MdV,

I mentioned your comment to FOREX Trader because he doesn't really follow the comments.

Regarding 50:1 leverage, he said that retail brokers usually offer up to as high as 400:1 leverage to would-be currency traders. But he said that you'll rarely see professional FX traders using more than 20:1 leverage, and even then it's usually only the day-traders using that much leverage. He said at his office it's generally more like 3:1 or 2:1.

When you increase the leverage, there is a massive increase in the "cash flow" of the invested capital, but it also increases the potential for a margin call, which he says is obviously why retail brokers offer such high margin. For example, at 50:1, you'd only have to deposit $20,000 to hold that $1M XAUUSD short overnight and earn the $16. That equates to an annual interest rate of 21% which is HUGE. But the downside is that a 2% adverse move in the underlying is going to mean a margin call, which means you could lose the whole $20K if gold goes up 28 bucks and you don't have more cash to wire to your broker.

At 400:1 leverage (just for fun), you'd be earning a "carry" (interest rate differential) of 170% annualized. But the bad news is that gold would only have to move up $3.47 before you would either lose your whole wad or have to deposit more. Imagine having to deposit another $20K each time gold moved up $3.50 and you've only got $100K. If gold goes up $18 you'll lose the whole $100K, even if it then goes into free fall right after you went broke.

My point is, the high leverage offered by retail FOREX brokers is probably a cash cow for them (not you). But the real pros (like FT) are only using 2:1 or 3:1 leverage.

With lower leverage, he says: "This is where the technical trend comes in, allowing you to run your carry position with a tight "stoploss" that should stick unless the trend reverses. If you're a large investor with cashflow requirements (think pension funds and whatnot) then positions like this can be a moderately attractive way of earning a 5% "yield" in an otherwise yieldless market."

Sincerely,
FOFOA

How many other gold writers have you seen that have even mentioned this $240B+ per day segment of the gold market, let alone analyzed its impact on the price of gold? In my last email, I told you how I answered someone who asked, "Can you point me somewhere (or perhaps you have written about it - and it has escaped me) what determines the daily (paper) Spot price. Does anyone know the factors involved?" Think about the relative weight of this $240B+ paper gold market as you read the bolded part at the end:

Have you ever noticed that the spot price is often slightly different depending on where you look? I just opened Kitco and APMEX simultaneously and the ask is $1,295.70 on Kitco and $1,296.20 on APMEX. The answer is that there is no official spot price. Everywhere you look for it the price you see quoted will either be from a live trading platform and, therefore, the opinion of thousands of traders who are looking elsewhere for reference, or else, as with Kitco and APMEX, it will simply be reporting the going price on some active trading platform. So there is no official spot price. There is only the opinion of thousands of traders who are all cross-referencing thousands of different correlated items, charts and other active trading platforms in search of an opportunity at any given point in time.

Which segment of the gold market do you think carries the most weight when it comes to determining the spot price of gold at any moment in time? GLD daily volume is around $2B. What is COMEX daily volume? Isn't it somewhere around $20B? And the LBMA reports a daily volume of $240B, 90% of which is "spot gold" or about $216B per day. So COMEX is about 10 times the volume of GLD, and LBMA "spot" is around 10 times COMEX and 100 times GLD. Does that sound about right, or am I getting something wrong here? I realize that I'm comparing "daily volume" to "daily volume" and there may be a margin of error due to differing methods of reporting "daily volume", but with an order of magnitude difference between LBMA "spot" and anything else, it's pretty safe to say that LBMA "spot" carries the most weight when it comes to determining the POG.

Here's a screen shot of a FOREX trading platform that "a big physical dealer out of the mid-east" provided to another gold writer. He said he uses this platform to purchase gold, and that he also takes delivery from the platform provider (FOREX Trader said that would be called a "physical ECN" if true). As this particular story went, he was able to buy and sell as much as he wanted, but was, on occasion, limited as to how much he could take immediate delivery on. Here's a quote from the story as it was told: "…physical orders were getting partially filled. If they ordered say 10 Kilo's they would get 5 or 4 as confirmation, and would have to wait for delivery of the balance."

I asked FOREX Trader if this screenshot looked like a physical ECN to him and here's what he said:

"There is no way I can verify based on the screenshot whether or not his access is to any physical ECN. But from my personal experience, it doesn't look like it. To me it looks more like any regular bucketshop CFD brokerage account. First of all, the spread (60c) is 10c higher than most CFD brokers offer, and definitely way higher than what you get on the interbank at 3:30PM London, 30 mins after the fix! Secondly, all you can see is the spread, you can't see the market depth even 1 level down. For example, I link a screenshot of MB Trading (which is an ECN -not interbank- broker that I do have an account with) http://www.onestepremoved.com/wp-content/uploads/2012/02/sampleMarketDepth.png, thirdly it only seems to show the ability to buy/sell at market (as opposed to limit orders), which is another very big red flag that it's a CFD account.

However, while all three of these points trigger my skeptical side, like I said I have no real way to confirm or deny whether he is trading a physical ECN, there are a million software packages out there, each broker often provided support for at least two and there is no standard on how they should look."

I mention this FOREX Trader email for a couple of reasons. First, notice the term "interbank". Here's what Wikipedia says about the interbank:

The interbank market is the top-level foreign exchange market where banks exchange different currencies.[1] The banks can either deal with one another directly, or through electronic brokering platforms. The Electronic Broking Services (EBS) and Thomson Reuters Dealing are the two competitors in the electronic brokering platform business and together connect over 1000 banks.

The point I want to make here is that there seems to be a kind of pyramid structure to the FOREX market, with the interbank at the top tier of the pyramid. Down at the bottom of the pyramid you have the retail FOREX trading platforms available to you and me. You have to be a bank or a pretty big player, a wholesaler or a middleman to deal directly with the LBMA bullion banks as evidenced by the number of trades reported in the LBMA survey. The daily average reported was 6,125 trades totaling $240B. That breaks down to about $39M per trade, or 9/10ths of a tonne.

And that's why I think that this segment of the "gold" market could be larger than $240B per day. So what's the dog, and what's the tail? Remember that Another said, way back in 1997, "And Comex is nothing, if "only a silly game". Worldwide trading in gold could be cut in half and still equal all the metal in existence!" He also said, "Comex is a side show!"

It would be interesting to see how the LBMA would explain those 6,125 trades averaging $39M per trade, which over 36 reporting members averages out to 170 trades per LBMA member per day, each at almost 1 tonne. It's a stretch to imagine even a top tier FOREX ECN (electronic communications network) in which the average trade is $39M. So I imagine the LBMA would simply say they were OTC spot unallocated transfers between clients. But then who are those clients? I imagine they could include FOREX trading brokerages, some of which are owned by the bullion banks themselves, and each of which would carry a gold-ounce-denominated balance, directly or indirectly, with a real bullion bank that also deals in physical. A kind of FOREX brokers' gold-ounce-denominated liability clearing system for the various ECNs.

I suppose you could say that gold trading as a currency is, to an extent, "backed" by the much smaller physical segment of the market. In other words, "gold trading as a currency" requires, needs, depends upon a functioning physical market which trades at parity to paper gold. But the physical portion of the market does not require, need or depend upon the paper side. It's not a symbiotic or mutually beneficial relationship. It's more like a parasitic relationship, where the parasite cannot survive without the host, but the host will be just fine, even better, without the parasite.

How does this tie back into everything else I write about? Well, I think it should help you understand how the price of gold is not driven by the physical segment of the market, and therefore parity between the two is not as solid as it seems.

Of course there is no ironclad proof that the majority of LBMA volume in that survey is FOREX trading, but I have yet to see a better explanation, or any other explanation for that matter. As far as I'm concerned, that is the explanation until I see another contender. Can you think of any other activity the bullion banks are involved in that could account for $240B daily volume in gold trading?

I'm sure that some of that volume is straight-up unallocated gold savings (as opposed to trading) accounts, and some is probably physical changing hands, but the vast majority must be gold trading as a FOREX currency. And tell me, what would be the difference between a plain-vanilla unallocated gold account at a BB and an XAUUSD trading account balance at that same bank? The answer is absolutely nothing! Those gold-ounce-denominated credits are essentially the same thing. You can even ask for physical delivery from a FOREX trading account if it is with a bullion bank that deals in physical, which is why I mentioned that screen shot and the story from the large Mid-East gold dealer.

This astounding volume has been known since 1997, but have you seen anyone talk about it relative to COMEX or GLD? Today the LBMA "daily clearing volume" is $29.9B, and from that survey we know that total volume is roughly ten times clearing volume, so that means total volume could be up to $300B per day now. Here is the average daily clearing volume from Oct. 1996 through present, in ounces, $ value and number of transfers. The 2011 survey is the only thing concrete that we have to show how "total volume" relates to "clearing volume", but even with a margin of error, how else can you possibly explain these volumes?

We know the FOREX market is huge. We know that gold (XAU---) is part of that market. And we know the LBMA released its astounding volume data for the purpose of demonstrating that gold is a deep and liquid market. 2+2=4. I think it's really that simple, even if no other gold writer mentions it. But if anyone has a better explanation for that volume, I'm all ears! ;D

Today, any paper gold is just as good as real physical gold for the purpose for which people buy gold, which is to buy it today and sell it later, or as a hedge. Any paper is just as good as physical as long as they trade at parity!

You brought up the argument that "the people playing this game don't want gold, they just want to trade its volatility." True, and also some want it as a hedge or insurance for other investments. But what they all want is provided by paper gold as long as paper and physical trade at parity. They don't want physical because, today, there's no functional difference between paper and physical except that physical costs more to store. But when paper gold fails to perform that function for which everyone buys "gold", they'll want what the physical holders got. So it doesn't matter that they don't want delivery today. They still do want the same thing from "gold" that everybody else does, which is exposure to the price action in physical gold. But today they are only getting exposure to the price action in their massive paper gold market, which has a tenuous parity relationship with the much smaller physical market.

Here is FOA talking about how the paper gold holders think they are betting on what's happening in the physical segment of the market when, in reality, the physical segment is struggling to trade at prices determined in the oversized paper segment of the market:

Clearly, the intent of this paper market, is to bet on the price of gold as it is determined by the buying and selling of other physical traders. The western public should take these trades for the concept they truly represent. ""I (the long side) bet on the "price" of gold not because we need or want the physical metal. Rather, my wager is that others will need real gold to protect themselves from bad monetary systems. In fulfilling that "need to own", these others will drive up the dollar price and I will make money while working within the confines of our good monetary system.""" The shorts make the opposite bet, in that they think the world monetary system will work itself out and induce "the others" to sell all their gold. That is, gold they bought in the first place, because they did not know that our money managers could repair the world financial system.

Yes, today Western longs and shorts are playing out these two views of the gold market. Yet, both sides are using paper gold bets to represent their beliefs. Truly, the major majority of this market does not buy or sell physical gold to represent their investment concepts. There are a few that buy coins and bullion, but, even in their large amounts, it is only a drop in the paper gold bucket.

This, my friends, is the very nature of western trading of gold. The mindset is to treat it as a concept for making currency, not protecting existing wealth. […]

There are many mental angles and philosophical side steps one can take when understanding the above. But, in this concept lies the very basis of the flaw in the current gold market. A paper market, built upon world misconceptions of currency values and the historical reasons for owning gold. The present deployment of world assets into a paper system of valuations is likened to traveling a trail of no return. History has shown that the assets accumulated in this way will never be transformed into "the things of life"! The paper wealth you currently own is nowhere near the real value your currency says it is. With the above introduction, we have begun close to the end of this journey. In the upcoming chapter one, we return several miles to walk ground already well traveled. We will observe concepts on the right and the left, not discussed by other guides. The very sights that make such a trip, "worth wile".

"You will see this trail thru the eyes of history and feel old ways as new Thoughts!" Another

I dug out a few more quotes from FOA for you, to hopefully encourage you (and others) to dig into the archives yourself. Here FOA mentions how the paper price of gold can fall even in the face of high physical demand:

"Another" counseled later that the gold market, as we know it was in danger of failing. In this case, failing means less and less major players are offering bids for future paper in the top tier markets because the gold can't be supplied. This loss of bids allows the paper price to fall further as present paper holders also attempt to sell. This is the "EXACT" reason that gold does not respond to the major financial events of today! Believe it! Local downstream physical dealers, because they use the Comex and LBMA paper market as a price creator, continue to sell gold at lower prices even as buyers come in droves.

The large funds don't want the trouble of real gold so they continue to play this game of "let's bet on the gold price and see who is right"! Today, they are learning a painful lesson that the stated price for gold is established by the same derivatives that they don't want to exercise. In their world, they are convinced that massive physical gold is but a phone call away for shipment into certified warehouses, so the derivatives price must truly reflect the real market.

The end work of this process has found the 3,000 or 5,000 ton per year real bullion market, is little more that a sea shell on a fifty mile beach. Everyone on the "gold net" already knows how much LBMA trades and that is small stuff compared to the other unseen world markets. The debth and liquidity of the paper market moved the bullion trade into the "pink sheets". Needless to say, today, the famed "closing bullion price" is set by the cash commitments that bid for derivatives, not the cash that bids for bullion. In the old days, really big traders would arbitrage any such paper overhang against bullion by calling for delivery. Today, with the paper market so large, any such power play would find most traders taking delivery of gold as the market is sold out from under him. Besides, this new market perspective works against any long traders because none of the present "derivative gold demand" wants delivery! They only want to settle in cash, because taking delivery would require selling their other "better performing" investments. The mindset today is that gold is only an insurance hedge, as such "an increase in its price will settle up in a cash delivery to me, to offset my other risk of cash impairment to my portfolio"! To further develop: "I don't need physical gold, I only need to participate in its price movements"!

In complete satisfaction of the current trend, derivatives fill the bill for this current gold market. Clearly, we can see that this new market is not "fraudulent". There is nothing wrong with players pouring margin money into the short side to create a demanded product! It's has evolved into a cash game. This is where GATA is fighting a war they cannot win. Gold bugs (of the last few years) were viewing the present market using 70s eyes. Indeed, they were investing in an industry that was losing primary demand for its product, even as "the need" for that product was exploding. This new gold market found a way to channel the "modern need" for gold's attributes away from physical demand and into paper supply. You simply can't create a short covering run if none of the current (insurance) longs want to take delivery. Even worse, as this trend was further developed, more and more old private physical holders were selling their gold and holding paper instead. Add to that Western dollar supporters wanting their currency to look good, and we have paper gold supply that's also used as a form of positive currency intervention. Anyone investing in the gold industry, expecting bullion to explode from all the new demand was truly disappointed. For every new Western gold bug that wanted gold for insurance, there were five paper sellers to supply him with all the gold insurance he needed, at a fraction of the cash commitment. Peter, (if you are still with me) this is only the end of this act, not the end of the play. We have been standing on the trail and looking at where we have just travelled. Now, let's turn around and look forward.

[…]

Once again, the needs of investors will redirect the method of using gold. As the wealth effect of the Dollar/IMF system goes into reverse, the process of receiving your gold hedge insurance in dollars will be perceived as a risk. At this stage, all of the past demand for gold that was channeled into cash settled paper derivatives will suddenly reverse its trend. Slowly, more and more of a percentage of settlement will be asked for in real gold. As delivery fails from increased demand, existing derivatives will be dumped upon the market place in an attempt to cash out. This very process will: First dry up all gold supply and lock down any existing private stocks. Second, cash biding on the dealer market will become convoluted and reflect only gold's currency value. It's economic / industrial use will be priced totally out of the market. Third, what was once the world price making market for gold, will become useless for delivery as its contracts are defaulted on and discounted in price. What price could the world gold price be set at, using these defaulted, bond like securities? How low does russian debt trade?

I pulled these quotes by searching the term "paper market" and, yes, there were lots of hits. Here's one quote I'm including because it could almost explain what we saw over the next 14 years up until today in the gold market:

Remember, the present financial system has a need for new mined gold to flow into derivatives at a low price to support the paper market. The same paper market that keeps oil behind the dollar also holds the dollar together. As of today; To further pull existing "old gold" from portfolios by forcing the street price down now invites a run from the dollar. A high physical "street price" will at least keep the dollar in play when price inflation begins. If the paper gold price rises from its present level, will gold stocks follow? Probably! But what if that rise ends quickly as the gold market begins its next "official" failure run?

Is that where we are in 2013, in the gold market's next official failure run?

Slowly, everyone is coming around to understanding how our gold markets got so far off track. The official determination of what constitutes "buying and selling gold" never started this way. In the beginning gold was wealth and people traded it as money. Jump ahead to the US timeline and we see currency a gold loan that didn't pay interest as it was the US dollar. You loaned your gold to the treasury and they gave you a contract stating that your metal was held until asked for. Your contract stated that 1/35 ounce of gold was owed you, on demand. Because no one asked for their loan to be repaid, the treasury just kept creating more loan contracts even though there was not enough gold to repay with.

After this "gold loan scam" went bust around 1971, they went back to using real gold again. The government allowed trading in physical in the US just as it was done in the rest of the world prior to this event. Then someone used the gold fabrication industry as evidence of a "need" to create a US futures market so suppliers could paper hedge risk. No need to make the point that this paper market was of little need as the gold industry had worked well for thousands of years without it. Indeed, another form of gold derivatives was just born. The gold market was destine to evolve again as the distinction between trading real bullion and betting against someone on the direction of the metal's price movements became one and the same. People accepted that a gold derivative was just as good as gold as the pre-1971 dollar was. We came full circle.

Pulling these quotes is actually fun for me, so I could keep doing this all day, but then this email/post would be 40 pages long. So I'll leave it at this for now. But there's much more in the archives. I only scanned less than 25% of FOA's posts to pull these quotes.

The point is that the paper gold portion of the gold market is where the price of gold is discovered, and it appears that gold trading as a FOREX currency is the largest portion of the paper gold market, by an order of magnitude even. The daily physical flow from mining and recycling is around 16 tonnes while the LBMA tells us that their spot unallocated flow is in excess of 2,400 tonnes per day. Here's one last quote from FOA:

Gold is valued by the number of outstanding claims against it. Kind of like a house for sale with ten bidders. Each bidder thinks the house is in the bag because they have a valid bid ticket. Each one thinks he can have the house at any time, even though nine others want it too, because all I have to do is bid a little higher and take it! Insane, but that's what is going on! Somehow, the BIS and the major private gold holders know the total claims, as does Another.

Total loco London gold turnover in the first quarter of 2011, as reported by 36 LBMA members, was $15 TRILLION. Total turnover as reported in ounces was 10.9 BILLION ounces, or 340,402 tonnes over 63 trading days. That's a lot of trading! I wonder which market that includes "gold" has the depth and liquidity to entertain such volume, since it's obviously not the physical market, GLD or even the futures markets.

"The area where I’m still hazy is the gold as a FOREX currency."

Is it still hazy? ;D

Sincerely,
FOFOA

And the light bulb goes on!

Awesome, thanks for this. I’ll re-read again and get back to you in a few days… got a bit going on right now.

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